by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] There is a lot going on this morning.  Let’s dive in:

Trade wars: President Trump campaigned as a trade warrior, promising tariffs and government intervention to boost manufacturing employment and give hope to his electoral base.  However, in his first year of office, if one ignores social media, Trump would be indistinguishable from an establishment Republican.  Tax cuts were the focus and were successfully passed.  Even the budget, which increased the deficit, isn’t inconsistent with previous GOP administrations.  But, lurking under the surface is a president who wanted trade retaliation.  As establishment figures within the administration fade in influence, the president is swinging toward his instincts to impede trade with the idea that this achievement would return the U.S. to a period of mass industrial employment.

In calls yesterday, advisors wondered if he might walk back this policy in light of the drop in equities.  It doesn’t appear this expectation will occur; we note the president tweeted this morning that “trade wars are good and easy to win.”  Needless to say, the establishment GOP is apoplectic.  Editorials in the national papers are calling the announced tariffs a disaster.  No one should be surprised by his actions; he won the presidency as a populist and, unless that stance was a complete sham, at some point this part of the president’s persona was going to emerge.

The problem, of course, is that trade is complicated.  First, when a nation implements trade sanctions, other countries can retaliate.  The U.S. has generally not taken aggressive steps over the past 40 years but that isn’t to say they never occurred.  Nearly all administrations since Carter have taken limited steps in various markets to send signals that nations that engage in unfair practices will face penalties.  But, economic theory rightly shows that trade barriers are a poor way to protect jobs.  For every job protected, other jobs are lost.  In this case, protecting steel jobs will likely raise prices on the end users of steel, e.g., autos.  Second, the U.S. has a particular issue in that it is the provider of the reserve currency.  The world economy is dependent upon the U.S. to run trade deficits in order to provide dollars for global trade.  We can argue for days as to whether or not a single nation should have that role, but the reality is that if the U.S. puts up trade barriers it raises the risks of a global recession.  The U.S. provided the reserve currency to win the Cold War, but policymakers haven’t come up with a more compelling reason to continue the policy since the Berlin Wall fell.  To be fair, there have been losers to trade, which is, by design, unfair.  After all, if the system creates incentive for foreign nations to accumulate dollars for trade and the safest way to get dollars is by running a trade surplus with the U.S. then the system invites unfair actions.  If the U.S. wants to maintain that policy to support world growth, the losers in trade have to be adequately compensated.  That arrangement really hasn’t occurred so some parts of the economy are harmed by trade (manufacturing), while other sectors involved with supporting trade (transportation, finance) benefit more than they would have otherwise.

In this week’s Asset Allocation Weekly Comment (see below) we discuss the difference between cyclical and structural inflation.  Much of the current worries about inflation are cyclical; economic slack is being steadily absorbed and there are legitimate reasons for concern.  However, this cyclical inflation pressure is in the context of disinflationary structural forces.  As long as the U.S. allows the free implementation of technology and is open to trade, inflation tends to remain depressed even during periods of cyclical tightness.  The president’s actions raise the risk that the structural forces that have been steadily depressing price inflation may be reversed.  One measure on steel doesn’t make a complete reversal.  However, even the idea that these trade measures are proper raises the potential that this recent tariff is the opening move in a much broader policy to restrict trade.  If this is the case, the somewhat benign environment for financial assets over the past four decades will evolve into something much more difficult.  We are not there yet, but it is a condition we are closely watching.  Market action so far is worrisome.  Today we are seeing the dollar tumble and interest rates rise.  If the world is concluding that the U.S. is no longer a reliable steward of the reserve currency, we could be heading into a world of great financial tumult (stagflation, higher volatility).  It’s too early to make this call, but market action so far is a concern.

It wasn’t just Trump: At the end of Chair Powell’s testimony yesterday, NY FRB President Dudley suggested in another speech that four rate hikes this year would be considered “gradual.”  That statement also contributed to the equity decline yesterday.

Brexit: PM May is giving a speech at the time of this writing, discussing her government’s position on separating from the EU.  Thus far, it’s mostly platitudes with no substance.  We think May is stuck; the majority of her party wants a hard Brexit but the majority of Parliament wants a soft Brexit, with the U.K. staying in the customs union.  At some point, there will be a vote of no confidence, new elections and the real possibility of PM Corbyn.

Italian elections: The Italians go to the polls this weekend.  We don’t have any new polling data (polling is not allowed before elections so the last poll was Feb. 16^th).  Markets are expecting an inconclusive result but, as we discussed in recent WGRs,[1] all parties want fiscal expansion.

SDP decides: The rank and file of the SDP decides this weekend whether the center-left party should join in another grand coalition with the CDU/CSU.  The SDP faces a real problem.  If it votes not to join the coalition, new elections are likely and current polling suggests the party might be less popular than the AfD.  On the other hand, joining the conservatives further blurs the difference between the center-left and center-right and could simply lead to the extinction of the SDP.  We think the 460k members of the SDP will decide to join the coalition but the vote will be very close.

BOJ at the end?  BOJ Governor Kuroda indicated today that the Japanese central bank is planning to begin the process of withdrawing from excessive accommodation in 2019.  The JPY jumped on the news.

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[1] See WGRs, The Italian Elections: Part I (2/12/18) and Part II (2/26/18)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Risk assets are coming under pressure this morning as equities struggle.  Here is what we are watching today:

Powell, Part 2: Chair Powell testifies before the Senate Banking Committee today.  Usually, the second testimony is not closely watched; after all, we have already seen the formal testimony and Q&A either a day or two before and accordingly there shouldn’t be much new information.  However, we have seen instances when a Fed chair, concerned that the financial markets misunderstood the earlier message, attempts to adjust market expectations.  Thus, if Powell didn’t intend to signal that a fourth hike is possible this year, look for him to make a point that inflation remains under control despite economic strength.  He can make this case fairly easily with the Fed’s preferred measure of inflation, core PCE, remaining below target (see discussion below).

Energy recap: U.S. crude oil inventories rose 3.0 mb compared to market expectations of a 2.0 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  What we are seeing is very bullish—the usual seasonal build in stockpiles isn’t occurring this year.  The longer this continues, the more fundamentally bullish this becomes; thus, even with the higher than expected build this week, it is important to realize that the change in stockpiles is well below where it should be.

Based on inventories alone, oil prices are undervalued with the fair value price of $66.37.  Meanwhile, the EUR/WTI model generates a fair value of $75.32.  Together (which is a more sound methodology), fair value is $72.55, meaning that current prices are below fair value.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Financial markets are treading water this morning after a hard sell-off yesterday.  The proximate cause was Chair Powell’s testimony to the House Financial Services Committee.  Here is what we are watching this morning:

The Powell testimony: Although his prepared remarks were unremarkable, his comments on the economy were rather upbeat.  He suggested that the combination of a fiscal tailwind and improving exports are leading to accelerating growth.  These comments were made in the context of a question on whether the median FOMC forecast of three hikes this year is still relevant.  Powell suggested that the economic outlook has improved since then, leaving open the possibility of four hikes this year.  Market reaction was swift and relentless.  Equities and fixed income prices fell, commodities dropped and the dollar rose.  The Fed chair is suggesting that, at long last, cash may become an asset class again, which is unwelcome news for nearly all other asset classes.

Was the market reaction justified?  Although pundits were belaboring the point that there wasn’t really anything new in what Powell said, there is another issue that bears examination.  Powell isn’t an economist.  We cannot observe a record of academic publications that would offer us any insight into what he actually believes.  His voting record as a member of the FOMC doesn’t provide any real insight, either—he voted with the chair.  So, in reality, we really don’t know how he personally leans in terms of policy.  The upbeat assessment of the economy could be an indication that he is more hawkish than assumed (we rate him as a “3” on our “1” (extreme hawk) to “5” (extreme dove) scale).  Again, it isn’t clear if what we heard yesterday signals any clarity on Powell’s actual policy stance.  We will probably need a series of comments and speeches before we can determine what Powell really thinks.  Until then, expect higher than normal volatility around his comments.  We will get an important clue tomorrow—if Powell did not want to signal four hikes and didn’t welcome the market reaction, he has the chance to soften his position when he testifies before the Senate Banking Committee.  It is a rather common practice for Fed chairs to adjust market expectations by using the first testimony as a sort of trial balloon.  Thus, we will be watching to see how Powell reacts to the sharp market response we saw yesterday.

Expectations of policy tightening are rising: In observing the implied three-month LIBOR rate from the deferred Eurodollar futures, the financial markets are now taking the dots plot seriously.  The charts below show that the weekly implied three-month LIBOR rate is well above the highest levels seen in 2011.  The right-hand chart shows that the FOMC tends to raise rates until fed funds match the implied LIBOR rate.  This chart clearly indicates the Fed has “runway” to raise rates significantly, toward 3.0%.  It should be noted that the implied LIBOR rate falls to the level of fed funds in several tightening cycles, signaling to the FOMC that it should stop raising rates (the crossovers are shown with vertical lines).  Thus, the implied rate doesn’t necessarily mean that a 3% rate is a guarantee.  But, it does suggest that, for now, the financial markets are discounting tightening.

Is the economy doing all that well?  There is no evidence of recession, but the economy isn’t all that robust, either.  Below we note Q4 GDP data.  The Atlanta FRB GDPNow assessment is that Q1 growth is going to be in line with Q4.

In looking at the estimates of contribution to growth, weakening consumption is the largest element of the declining forecast, which began at 4.2% and has declined to 2.6%.

Brexit is evolving into a political crisis: PM May is rapidly being pulled into a political maelstrom.  Her party is a mix of “hard” and “soft” Brexit supporters.  The soft supporters accept an EU exit but want to remain in the trading union.  This would not be a good outcome; the U.K. will then be forced to accept migrants and EU rules without the benefit of representation.  However, remaining in the trading union will preserve London’s role in finance and bring less disruption to the economy.  The hard exit supporters want a complete break with the EU; this stance has proven difficult to manage.  The EU is pushing for a hard border between Northern Ireland and Ireland which could undermine the fragile peace deal between those two states.  The disruption to the economy from a hard Brexit could be massive.  PM May has been trying to weave a path between these two camps in her party; our read is that the majority of her members are hard Brexiteers but the actual majority in Parliament are soft Brexiteers.  This division is being exploited by the head of the Labour Party, Jeremy Corbyn, who has positioned the Labour Party to support a soft Brexit.  Corbyn’s position is threatening to divide the Tories, who only have a majority in government because of a coalition with a small Unionist party in Northern Ireland.  So far, 10 Conservative MPs have come out in favor of a soft Brexit.  Given that the Tory/DUP coalition only has a one-seat majority, PM May is under threat of a no-confidence vote.  If she loses, we expect elections and there is a real possibility that a Labour coalition could gain power.  A Corbyn-led government will terrify the financial markets.  For the U.S., it would be a preview of a Sanders or Warren presidency.  Although we still believe the GBP is cheap, all bets are off if the May government falls.

Rethink on TPP?  At an NPR interview, Treasury Secretary Mnuchin indicated he is engaged in “high level talks” with the other 11 members of the TPP and the U.S. might consider rejoining the group.  His comments were not a complete surprise; President Trump suggested something similar at Davos.  Without details, it’s hard to understand what rejoining TPP would look like, but we think this is further evidence of the establishment/populist divide within the Trump government.  The populists are horrified by trade and see multilateral agreements as job killers; the establishment sees agreements like NAFTA and TPP (and TTIP) as (a) ways to contain inflation and labor costs, and (b) methods of maintaining America’s superpower role.  We suspect the president uses the TPP comments as a way to encourage the establishment members of his coalition but, without actual action (and we don’t expect any to occur), this is just talk.

Consumer confidence: Yesterday, the Conference Board reported that consumer confidence hit a new cycle high.  We note that consumer confidence correlates highly with P/Es.  Thus, the rise in confidence is a bullish factor for equities.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Financial markets are very quiet in front of Chair Powell’s testimony before the House Financial Services Committee.  Here are the news items we are watching:

Powell’s formal comments: A quick reading of Chair Powell’s first formal testimony indicates that the Fed sees the economy as strong and inflation remains under control, although some of the low readings are due to transitory factors.  Thus, gradual rate increases are to be expected.  Although we have seen a mild uptick in rates since the release of his comments, in reality, nothing here is a shock.  Oral testimony begins at 10:00 EST.  While we expect Powell to conduct himself in a professional manner, since he is new to the role, there is always a chance of fireworks.

Military shakeup in Saudi Arabia: The Kingdom of Saudi Arabia (KSA) fired its top military commanders, including the chief of staff and the heads of the air force and ground forces.  We suspect two reasons for the move.  First, the war in Yemen is going badly and new leadership is probably needed.  Second, the crown prince, who is essentially the de facto leader of the KSA, is likely promoting his own loyalists to these positions.  Having the loyalty of the armed forces is a necessary component of political stability.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

There was a lot going on this weekend.  The Winter Olympics ended without incident and there was lots of news out of China.  Here is what we are watching:

Xi as leader for life: At the CPC meetings in October, the party suggested that Chairman Xi could be planning to remain head of the communist party after two five-year terms.  Xi has systematically eliminated rivals and surrounded himself with allies.  It should be noted that the policy of chairing the CPC for just two terms is not law but a custom created by Deng Xiaoping to prevent another Mao.  However, the chairman of the CPC is also the president of China; in other words, that person is both head of the party and head of state.  The president is (or, at least, was) restricted by law to two five-year terms.  Over the weekend, the government indicated that the term limit law would be abolished at government meetings.  In some respects, this is a surprise.  Although the real power in China lies with the CPC, a formal change in the constitution to allow for more than two terms as president is important because it gives Xi (and his successors) formal power.  We will have more to say on this issue going forward; for now, given the jump we saw in Chinese equities, this is being seen as positive.  However, in the long run, it sets up another potential Mao and a new cult of personality.

Chinese debt: Last week, we commented on the Chinese government’s effective seizure of Anbang insurance.  We suspect that much of this action is designed to corral debt growth.  A handful of Chinese conglomerates have used leverage to buy foreign assets, a practice that, at one time, was supported by Beijing.  As Xi moves to deleverage it signals to these debt-laden conglomerates that it is now time to not only stop borrowing but it is also necessary to actually reduce debt.  However, it isn’t clear to us whether it will be sufficient.  Local government borrowing is also significant and will be much harder to reduce without significantly slowing growth.  At the same time, if Xi wants to move in this direction, he clearly has amassed enough power to do so.

North Korea: There are two trends we are watching.  First, North Korea is apparently signaling a willingness to negotiate with the U.S.[1]  It isn’t clear what would actually be discussed; the U.S. wants North Korea to give up its nukes and that is probably a non-starter for Pyongyang.  North Korea would probably like a formal end to the Korean War, which the U.S. has never fully granted, and sanctions relief.  Washington will only give in to those desires when the nukes are gone.  At the same time, the U.S. has now sanctioned individual vessels apparently engaged in sanctions busting.  We are getting about as close to a blockade as one can get without a formal blockade, which is an act of war by most measures of international law.  We continue to watch these parallel tracks but believe we are probably closer to war than peace.

Trump 2.0: In the administration’s first year, despite lots of populist rhetoric and fiery tweets, this has looked like a GOP establishment government.  Regulations and taxes have been reduced.  However, we are approaching the period when the first principal figures begin to leave the administration.  In other words, we may shortly begin to see the generals and industry leaders exit to be replaced by persons less independent of the president.  The area we are focusing on is trade.  The White House is apparently considering a promotion of Peter Navarro to an assistant to the president.[2]  Navarro is a hardline trade warrior who wants to lift tariffs and bring about a trade surplus.  We also note that the White House is considering punitive tariffs on steel for national security purposes; interestingly enough, the military is cool to the idea, worried about undermining allies.  Overall, it is still unclear how this administration will evolve but, if we see a more populist government emerge later this year, then multiple contraction could offset the earnings boost facilitated by the recent tax cuts.

Other items: Chair Powell gives his first Congressional testimony later this week in his new role.  Italians go to the polls this Sunday, and we will also find out if the German Socialists will join with the conservatives to form a grand coalition. 

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[1] https://mobile.nytimes.com/2018/02/25/world/asia/north-korea-us-talks.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories&referer

[2] https://www.nytimes.com/2018/02/25/us/politics/peter-navarro-trade.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Xi versus Anbang: The Chinese government has taken control of privately held Anbang Insurance Group and arrested its chairman, Wu Xiaohui, charging him with economic crimes.  This is clear evidence that the Xi government is cracking down on foreign investment by China’s private sector.  Anbang is a large conglomerate that owns some trophy properties, including the Waldorf Astoria in New York.  The government is claiming the company had “illegal business operations which may seriously endanger the company’s solvency.”  A number of other large conglomerates with large overseas holdings have also come under government scrutiny.  There are two concerns; the first is that these conglomerates have sometimes used wealth products to fund their growth.  Since these require higher interest payments, there is likely worry among regulators that if one of them cannot service the debt incurred then it could undermine confidence in all wealth products as a class.  The second issue is more political; the CPC wants to maintain control over the economy and foreign investment tends to undermine that control.  Thus, cracking down on these high-flyers may work to scare other wealthy Chinese from seeking to move assets overseas.

May and the Tories formulate a Brexit plan: The Conservatives generally divide between hard and soft Brexit supporters.  The former want a clean break with no close ties with the EU, while the latter want to keep a customs union in place to maintain free trade with the EU.  Of course, with that outcome, the soft Brexit supporters will likely have to accept the free flow of immigrants and accept EU regulations, which creates the worst of all worlds—being in the EU but without any voice in shaping policy.  Thus, the hard Brexit camp is at least logically consistent.  However, leaving the EU’s customs union will mean severe economic disruption for the U.K.  The plan that has emerged is that Britain will try to negotiate a free trade deal with the EU similar to the recently completed one with Canada.  That deal would allow the U.K. to secure nearly all the benefits of the customs union without actually joining it in its current form.  There is almost no chance the EU will go along with this outcome.  We think the odds of another referendum are rising and May’s tenure is becoming increasingly shaky.  Labour’s leader, Jeremy Corbyn, has indicated he will call for a soft Brexit policy and recommend joining the customs union.  If enough Tories defect to this position, May could face a no-confidence vote and new elections could be in the offing.

Concern about Mnuchin: The EU minutes reveal that the ECB members were clearly worried the U.S. was about to embark on a pre-Rubin policy of currency jawboning, designed to weaken the dollar.  A rapid appreciation in the EUR would complicate monetary policy for the ECB, forcing it to likely maintain an accommodative stance.

Energy recap: U.S. crude oil inventories fell 1.6 mb compared to market expectations of a 3.0 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  What we are seeing is very bullish as the usual seasonal build in stockpiles isn’t occurring this year.  The longer this continues, the more fundamentally bullish this becomes.

Based on inventories alone, oil prices are undervalued with the fair value price of $67.34.  Meanwhile, the EUR/WTI model generates a fair value of $75.69.  Together (which is a more sound methodology), fair value is $73.14, meaning that current prices are below fair value.

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